The fraud triangle is a classic tool that advisors can use to reduce portfolio risk. It’s elegant, simple and effective at rooting out problem investments.
The term was coined by American criminologist Donald Cressey and describes the three elements that exist in all occupational frauds: pressure, opportunity and rationalization.
For advisors, the concept of fraud should extend beyond what can be proven in a court of law to include all the non-prosecuted manipulations that exist in the market on a regular basis. This includes stretching the accounting rules, promoting misleading non-GAAP results, making unfounded growth or profitability projections, or simply failing to correct street misconceptions when they are to the company’s benefit. By the time something reaches the courts, it’s usually too late for investors to recoup their losses. Better to proactively avoid situations that carry the hallmarks of past frauds or exaggerations.
The three elements
In the context of stock market manipulation, pressure often refers to the market’s expectations for profitability or growth. These benchmarks might be set by management guidance, prior results, peer performance or sell-side analyst estimates. The market can be fickle, and continually missing expectations (reasonable or otherwise) can lead to pressure from buy-side firms, investor activists and the board of directors.
Pressure can also exist in the form of incentive. Senior management may try to hit targets to increase the value of their existing equity or to trigger greater variable remuneration, such as the granting of share-based compensation. Management may also try to avoid negative triggers, such as staying within debt covenants by fudging the numbers.
The second element, opportunity, refers to being in the position (either individually or as a group) to influence the financial statements, override internal controls and alter their course. The vagueness of accounting rules and their reliance on significant management estimates provide ample means to alter financial results and trendlines. As noted in past articles, determined management often meets little resistance from regulators and financial statement auditors, much to the chagrin of investors.
The third element, rationalization, centres on a general disregard for the rules. Greed is fairly common and the world is full of opportunity, but fraud requires the perpetrator to rationalize their actions. Those prone to rationalization can be difficult to identify by an outside observer, but clues may surface in exaggerated claims, excessive bullishness or a general aura of inflated self-worth. These could be signs that management regards financial manipulation as temporary — or even a necessary means to an end.
Most recent financial statement frauds and significant corporate collapses checked these three important boxes. Advisors should watch for signs that have led to trouble for companies in the past, including:
- rapid growth in a competitive or burgeoning industry;
- the introduction of non-GAAP reporting metrics or the use of measures that don’t align with industry peers;
- significant debt or the risk of breaching covenants with just a few quarters of weaker-than-expected cash flows;
- management that is tight-knit or exhibits controlling attitudes;
- lagging close peers in terms of profitability or other key performance indicators, or outperforming without explanation;
- highly lucrative management compensation schemes that are biased toward rewarding riskier outcomes and extreme performance;
- growth through numerous acquisitions without pause to integrate operations;
- claims of novel technology that boasts industry-beating potential.
These aren’t the only signs of trouble, but they cover most notable Canadian and international collapses over the last quarter-century. The more elements present, the greater the likelihood of problems — suggesting a risky proposition that should be omitted from clients’ portfolios.
Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.